Acquiring for Cash

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Authentica, a digital security software company backed by five venture-capital firms, was in a tight spot last fall. Strapped for cash, with expenses cut to the bone and less than $1 million in annual revenue, it was desperate for additional capital. After searching in vain for a fourth round of outside funding, CEO Lance Urbas and finance director Lynn Wolf found themselves at the end of the summer with no new money and a valuation that had plunged from an April 2000 high of $63 million down to just $10 million.

Going back to their original venture capitalists — North Bridge Venture Partners, Greylock, Norwest Venture Partners, JPMorgan Chase, and the Intel 64 Fund — Wolf and Urbas were presented with an alternative form of cash infusion: an acquisition.

After helping the VCs search for a target among their portfolio of companies, Waltham, Massachusetts-based Authentica was allowed to issue stock for Shym Technology. The struggling Internet-security company had no customers or revenues, but it had about $7 million in cash. Authentica shelved most of Shym’s products, reduced the staff, and gobbled up the $7 million to use in promoting Authentica’s E-mail systems. “We acquired the company primarily for its cash and some key people who could enhance our team,” says Urbas, noting that Shym’s product line “really wasn’t the motivation for doing the deal.” Shym CEO Jim Geary was retained to advise the company part-time.

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Buying a company for its cash rather than its business may seem a tad avaricious. But experts say the merger-and-acquisition technique is being used increasingly in the current downturn to gain liquidity at relatively little cost. “If you’re a private company worried about getting capital, it’s a way to issue stock and get cash,” says Tony Jeffries, a partner at Silicon Valley­-based Wilson Sonsini Goodrich & Rosati, which has recently talked to several companies considering deals similar to Authentica’s purchase of Shym.

Venture capitalists themselves often are willing to go along with the approach — if the alternative is letting stagnant investments die on the vine. “These combinations are happening much more often, since they allow VCs to minimize their time and capital exposed,” says Scott Meadow, an entrepreneurship professor at the University of Chicago Graduate School of Business. Himself a 20-year venture-capital veteran, Meadow defines the acquisitions as “sideways deals”: not moving the VCs any closer to their exit strategies, but keeping hope alive for a later return on their investments.

At the end of the third quarter, VCs still had $124 billion locked up in private companies, many with little prospect of growing big enough to yield returns, according to VentureOne, a private-equity research firm. The funds have been able to exit from only 18 percent of the companies they first financed in 1999, while watching 22 percent of those firms go out of business, VentureOne says.

“I would think any VC is looking at these combinations,” says George Hoyem, former managing director at Redleaf Group, an early-stage venture fund. This past summer, Redleaf chose to merge two of its portfolio companies after one had been left at the altar by a public buyer. “We’d much rather have sold the company for a reasonable price or raised capital,” says Hoyem of the portfolio merger. “But we couldn’t do that in a reasonable time frame.” Another of Redleaf’s companies was combined with a private company that a different VC group had backed. Other big-name firms, including Battery Ventures and 3I, have put similar deals together in the past six months.

Multiple Drivers

To be sure, cash isn’t the only driver of such deals, although it usually is the primary one. In Authentica’s case, the company was able to license the rights to source code for one of Shym’s products. And VCs representing a target company are more likely to agree to deals with a strategic element, specifically if they combine companies in related industries in the form of a roll-up.

“Too many companies working in the same sector got funded,” says Bryan Pearce, an Ernst & Young partner who advises VC firms on their portfolios. “When you eliminate some of the crowd by merging, investors may be more willing to fund the combined single entity, since it will face less competition.” Ideally, cost savings and combined revenues build momentum toward a cash-out.

Even if a company’s VC backers welcome a merger, though, a consensus on the valuation and the manner of distribution can still be tricky. “It’s fair to say all our investors thought the combination was a good idea,” says Authentica’s Urbas. “But they were still concerned that the transaction was fair to all investors.”

Brokering that delicate deal fell largely to Urbas and Wolf. They had to talk some of their own investors into giving up senior securities after they persuaded Shym’s backers to agree to take the equity. (Authentica and Shym had a common investor in North Bridge Venture Partners, but that firm had to recuse itself from the decision because of potential conflicts.) The final split gave 55 percent of the combined company to Authentica’s original VCs and 45 percent to Shym’s group.

“It may be the best worst option that you have, because it at least creates an opportunity for the combined company to live a little bit longer, in hopes that either customer or capital markets open up again,” says Ted Stone, managing principal of August Advisors, an investment bank specializing in the technology industry. “From an objective standpoint, though, it’s not a very safe bet.”

Given the current predicament of many VCs, however, “it’s definitely a buyers’ market, with valuations very depreciated,” says Andrew Sherman, an attorney with McDermott, Will & Emery, which has advised on a number of such deals.

A few finance chiefs would agree. “There are fabulous opportunities out there,” says Dan Kossmann, CFO of OutStart, an E-learning software company in Natick, Massachusetts.

This past July, his company relieved one of its VCs of a nonperforming portfolio company — at a discount to the $1.2 million in cash it received in exchange for stock. “It was a very clean acquisition — the VCs did everything from negotiating them out of leases to terminating employees to getting rid of the furniture,” notes Kossmann. Plus, he was able to use the cash to acquire another capital-starved business that he believes could make OutStart profitable a quarter earlier than it had planned.

“No one knows when the market is going to open up again, but we are racing to build ourselves up into a company that could be listed on Nasdaq: $20+ million in revenues, profitable, with a nice growth rate,” he says.

In Authentica’s case, the infusion may also be working. The acquisition provided cash to crank up its marketing efforts, executives say, and to help the product fit the market better. Now, with more than $9 million of deals in the pipeline, Urbas says the company is on track to double its 2001 revenues this year and to turn profitable by the end of 2003.

Another benefit: the deal opened the door to more funding. The company closed a $4 million round with current VCs in September “just to give us a bit more of a buffer,” says Urbas.